Overview of cost and managerial accounting

Chapter one
Overview of Cost and Management Accounting
Contents
 Overview of cost and managerial accounting
 Comparison of cost managerial and financial accounting
 Cost classification concepts and terms
 The use of linear, curvilinear and step functions to analyze cost behavior
1. Introduction
Accounting is a very old science which aims at recording classifying, summarizing (recognizing,
measuring and reporting) of information related to a business entity. It can be broadly divided into
three categories: cost accounting, management accounting, and financial accounting. Cost accounting
helps the business to ascertain the cost of product/service offered by the organization and also provides
valuable information for taking various decisions and also for cost control and cost reduction.
Management Accounting utilizes the principles and practices of financial accounting and cost
accounting in addition to other modern management techniques for efficient operation of a company.
The main aim in management accounting is towards determining policy and formulating plan to
achieve the desired objectives of management. The scope of management accounting is broader than
cost accounting. Whereas, financial accounting is primarily concerned with record keeping directed
towards the preparation of profit and loss account and balance sheet. The information concerning the
business or enterprise is helpful to the management to control on business.
1.1. Objective of Cost and management accounting
Cost Accounting: - measures, analyze and reports financial and non financial information with the
objective of;
– To ascertain the cost of production on per unit basis.
– Helps in the determination or fixation of selling price.
– Helps in cost control and reduction.
– Ascertainment of costs division wise, activity wise and unit wise to determine profit.
– Helps to determine wastages and inefficiencies in the production processes.
– Provides information to the management for making decision.
– Helps in estimation of future costs.

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Management Accounting: - measures, analyze and reports financial and non financial information
with the objective of;
– Assistance in formulation of policies and plans.
– Helps in the interpretation of financial information
– Helps in controlling performance
– Helps in organizing on the bases of resources.
– Helps in the solution of strategic business problems
– Helps in coordinating operations
– Helps in evaluating the efficiency and effectiveness of policies
1.2. Cost and Management Accounting in comparison with Financial Accounting
1.2.1. Differences between financial accounting and cost accounting
Basis of Financial Accounting Cost Accounting
Differences
Objective Its objective is external reporting mainly Its objective is internal reporting to
to owners, creditors, tax authorities, management.
government and investors.
Maintenance of Accounts must be in accordance with the Cost accounting is maintained
Account statutory provisions of Companies Act voluntarily.
and Income Tax Act.
Profit Analysis Discloses profit for the entire business asShows the profit for each product,
a whole. process or operation.
Recording Records transactions in accordance with Records transactions in according to
the nature of expenses purpose for which costs are incurred.
Use of Control It does not make use of any type of It makes use of some important control
Techniques control techniques. techniques such a marginal costing,
historical costing, budgetary control
etc…
Stock Stock is valued at cost or market price Stock is always valued of cost price.
Valuation whichever is low.
Pricing policy It fails to guide the formulation of It provides adequate data for formulating
pricing policy of pricing policy.
Facts and Financial accounting deals mainly with Cost accounting deals partly with facts
figures actual facts and figures. and figures and partly with estimates.
Duration of Generally, financial accounting provides Cost accounting furnishes cost data at
Information financial information once a year. frequent intervals i.e., reports are daily,
Reporting weekly and monthly.
Evaluation of The information provided by financial The cost data helps in evaluating the
efficiency accounting is not sufficient to evaluate efficiency of the business activities.
the efficiency of the business activities.

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1.2.2. Differences between managerial accounting and financial accounting
Basis of Financial Accounting Managerial accounting
Differences
Report Report to external users Report to internal users
Orientation Past oriented Future oriented
Emphasis Give emphasis for procession Give emphasis for time
Focus Focus on summery data of entire Focus on segment reports
organization
GAAP Follow general accepted accounting Not follow general accepted
principles accounting principles
Generating of Generate financial report Generate financial and non financial
reports reports
1.2.3. Differences between cost accounting and managerial accounting
Basis of Cost Accounting Managerial accounting
Differences
Focus Focus on cost computation, control and Focus on how management set
reduction strategies
Scope Narrow Wide
Used data Quantitative Quantitative and Qualitative

1.3. Cost concepts, terms and classification

1.3.1. Cost concepts and terms
Cost: A resource scarified for specific objective or purpose. It is an asset initially and converted to
expenses. Cost is presented both in income statement in cost of goods sold section and in balance sheet
as inventory. In terms of time costs goes beyond one year i.e having a benefit more than one
accounting period.
Expenses: -A resources sacrificed to achieve a specific objective or purpose that has given a benefit
and is now expired. When the benefits are received, the cost becomes an expense. It is presented on
income statement as operating expense.
Loss: - a cost that occurs when goods or services are purchased or acquired and are determined
valueless without having provided any benefit are referred to as losses not expenses. This loss appears
as a deduction from revenues. Expenses and losses both reduce operating income, but are separately
disclosed as other expense section in income statement.
Cost accumulation—a collection of cost data in some organized manner (such as material, labor fuel
etc.) through accounting system.
Cost assignment—a general term that includes both cost tracing and cost allocation.
Cost tracing: - is the assigning of direct costs to the chosen cost object.
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Cost allocation: - is the assigning of indirect costs to the chosen cost object.
Cost object: Anything for which a separate measurement of costs is desired. Example: a product, a
service, a project, a customer, an activity, a department, and a program.
Cost center; Responsibility center where the manager is accountable for costs only.
Profit center; Responsibility center where the manager is accountable for revenues, costs and profit.
Revenue center; Responsibility center where the manager is accountable for revenues only.
1.3.2. Classification of costs
Classification is the process of grouping of costs according to their common characteristics. Therefore
costs can be classified in different ways from different point of view.
1) Based on traceability
a) Direct Cost – a cost that can be easily and conveniently traced to a specified cost object or costs
related to the particular cost object and can be traced to it in an economically feasible (cost-
effective) way. ( Example:- direct material and direct labor costs)
b) Indirect Cost – a cost that cannot be easily and conveniently traced to a specified cost object or
costs related to the particular cost object but cannot be traced to it in an economically feasible
(cost-effective) way (Example:- Indirect material and labor costs such as Janitorial service cost,
lubricants, screw etc).
2) Based on cost behavior
Cost Behavior refers to how a cost reacts to changes in the level of activity. As the activity level rises
and falls, a particular cost may rise and fall as well—or it may remain constant.
a) Variable Cost – a cost that varies, in total, in direct proportion to changes in activity level. In a
manufacturing company, variable costs include items such as direct materials, shipping costs, and
sales commissions and some elements of manufacturing overhead such as lubricants. In a
merchandising company, the variable costs of carrying and selling products include all items such
as cost of goods sold, sales commissions, and billing costs. In a hospital, the variable costs of
providing health care services to patients would include the costs of the supplies, drugs, meals, and
perhaps nursing services. When we say that a cost is variable, we ordinarily mean it is variable
with respect to the amount of goods and services produced.
b) Fixed Cost – a cost that remains constant, in total, regardless of changes in activity level (rent,
straight-line depreciation, insurance, property taxes, supervisor salaries, and advertising). When we
say a cost is fixed, we mean it is fixed within some relevant range the range of activity within
which the assumptions about variable and fixed costs are valid.

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Note: - At per unit cost level variable costs becomes fixed cost, fixed costs become variable
cost.
Example 1: - suppose the cost of coffee is birr 5 total variable cost will increase depends on the
number of consumers. Per unit variable cost (Average cost) and total variable cost is graphically
represented as bellow.
Per unit variable cost Total variable cost
Qty 1 2 3 4 5
VC/unit 5 5 5 5 5
Qty 1 2 3 4 5
TVC 5 10 15 20 25
Graphically presented as follows;

Per unit variable cost 30 Total variable cost

6
25
5
20
4
15
3
10
2
5
1
0
0 1 2 3 4 5
1 2 3 4 5

The graph of per unit variable cost or average variable cost is horizontal where as the graph of total
variable cost is vertical implies that the change in output level will change total variable costs
proportionally or in proportionally.
Example 2:- XYZ Company incurred 10,000 birr to acquire female’s beauty salon machine the
maximum service capacity of the machine is 500 customers. Total fixed cost is always 10,000 till it
reaches to economies of scale. But, fixed cost per unit cost changed in line with activity level.
Per unit fixed cost Total fixed cost

Qty 1 2 3 4 5 Qty 1 2 3 4 5
FC/unit 10,000 5,000 3333 2500 2000 TFC 10,000 10,000 10,000 10,000 10,000

Graphically presented as;

Per unit fixed cost Total fixed cost

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12000 12000
10000 10000
8000 8000
6000 6000
4000 4000
2000 2000
0 0
1 2 3 4 5 1 2 3 4 5

Based on the above diagram the line of per unit variable cost is downward where as the line of total
fixed cost is horizontal.
c) Semi-variable cost or semi-fixed cost: Many costs fall between these two extremes. They are
called as semi-variable cost or semi- fixed costs. They are neither perfectly variable nor absolutely
fixed in relation to changes in volume. They change in the same direction as volume but not in
direct proportion there to. An example is found in telephone charges printing costs etc.... The rental
element is a fixed cost whereas charges for call made are a variable cost. The distinction between
fixed and variable cost is important in forecasting the effect of short run changes in volume upon
costs and profits. Step costs graphically stated as follows;
9000
8000
7000
6000
5000
4000
3000
2000
1000
0
1 2 3 4 5 6 7 8 9 10

Step costs changed inconstantly within a given activity level i.e it increase up to a certain level then
constant after a stated level. This shows the behavior of both fixed and variable cost as stated in the
above diagram.
3) Based on production
a) Manufacturing Costs (product costs) – Costs directly related to producing of a product. Most
manufacturing companies classify manufacturing costs into three broad categories: direct
materials, direct labor, and manufacturing overhead. Direct material costs are the costs of
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acquisition of materials that eventually become part of the cost object (WIP and then finished
goods) and can be traced to cost object in an economically feasible way. Direct labor costs that
can be easily (i.e., physically and conveniently) traced to the cost object (WIP and then finished
goods). Include the compensation of all manufacturing labor i.e. wage and benefits paid to
machine operators assembly line workers who convert materials purchased to finished goods and
all manufacturing costs that are related to the cost object (WIP and the finished goods) in an
economically feasible way. Only those costs associated with operating the factory are included in
manufacturing overhead. Various names are used for manufacturing overhead, such as indirect
manufacturing cost, factory overhead, and factory burden etc…
b) Non manufacturing costs:- Costs could not directly related with producing of a product. It
includes Administrative costs incurred for administration is known as administrative costs.
Examples of these costs are office salaries, printing and stationery, office telephone, office rent,
office insurance etc. Selling and Distribution Costs: costs incurred for procuring an order are
called as selling costs while all costs incurred for execution of order are distribution costs.
Market research expenses, advertising, sales staff salary, sales promotion expenses are some of
the examples of selling costs. Transportation expenses incurred on sales, warehouse rent etc are
examples of distribution costs. Research and Development Costs: - In the modern days, research
and development has become one of the important functions of a business organization.
Expenditure incurred for this function can be classified as Research and Development Costs.
4) Based on management decision
a) Controllable cost /avoidable costs/. Any cost that is primarily subject to the influence of a
given responsibility center manager for a given period. Costs can be controlled or avoided by
management decision.
b) Uncontrollable cost /unavoidable costs/. Any cost that is not primarily subject to the
influence of a given responsibility center manager for a given period. Costs cannot be
controlled or avoided by management decision.
5) Based on financial statements
a) Inventoriable Costs – include all costs involved in acquiring or making a product (direct
materials, direct labor, and manufacturing overhead). inventorable costs are initially assigned to
an inventory account on the balance sheet. When the goods are sold, the costs are released from
inventory to costs of goods sold and matched against sales revenue to determine gross profit.

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b) Period Costs –are all costs in the income statement other than cost of goods sold. Period costs
are treated as expenses of the accounting period in which they are incurred because they are
expected to benefit revenues in that period and are not expected to benefit revenues in the
future periods or more than one accounting period. Expensing these costs in the period they are
incurred matches expense to revenue to determine net income. Such costs are stated on income
statement as operating expenses.

6) Other cost types

a) Prime and conversion costs:- Two more cost categories are often used in discussions of
manufacturing costs—prime cost and conversion cost. These terms are quite easy to define. Prime
cost is the sum of direct materials cost and direct labor cost. Conversion cost is the sum of direct
labor cost and manufacturing overhead cost. The term conversion cost is used to describe direct
labor and manufacturing overhead because these costs are incurred to convert materials into the
finished product.

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Example:- During the month ABC manufacturing business incurred $1,100,000 for direct material,
$500,000 for direct labor and $30,000 for factory over head cost. What would be the amount of prime
cost?
Prime cost = Direct material cost + Direct labor cost
= 1,100,000 + 500,000
= 1,600,000
Conversion cost = Direct labor cost + Factory overhead cost
= 500,000 + 30,000
= 530,000
Activity 1:- Based on the following information calculate prime and conversion cost.
Utilities, factory . . . . . . . . . . . . . . . . . . . . . . . . . . . $36,000
Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . $150,000
Depreciation, factory . . . . . . . . . . . . . . . . . . . . . . . $162,000
Direct material . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$780,000
Insurance, factory . . . . . . . . . . . . . . . . . . . . . . . . . $40,000
Supplies, factory . . . . . . . . . . . . . . . . . . . . . . . . . . $15,000
Administrative expenses . . . . . . . . . . . . . . . . . . . . $270,000
Selling expense . . . . . . . . . . . . . . . . . . . . . . . . . . .$250,000
Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000
Indirect material . . . . . . . . . . . . . . . . . . . . . . . . . . .$100,000
Maintenance, factory . . . . . . . . . . . . . . . . . . . . . . . $87,000
b) Opportunity cost:- is the potential benefit that is given up when one alternative is selected over
another. To illustrate this important concept, consider the following examples:
Example 1 Vicki has a part-time job that pays $200 per week while attending college. She would like
to spend a week at the beach during spring break, and her employer has agreed to give her the time off,
but without pay. The $200 in lost wages would be an opportunity cost of taking the week off to be at
the beach.
Example 2 Suppose that Neiman Marcus is considering investing a large sum of money in land that
may be a site for a future store. Rather than invest the funds in land, the company could invest the
funds in high-grade securities. If the land is acquired, the opportunity cost is the investment income
that could have been realized by purchasing the securities instead.
Example 3 Steve is employed by a company that pays him a salary of $38,000 per year. He is thinking
about leaving the company and returning to school. Since returning to school would require that he

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give up his $38,000 salary, the forgone salary would be an opportunity cost of seeking further
education. Opportunity costs are not usually found in the accounting records of an organization, but
they are costs that must be explicitly considered in every decision a manager makes. Virtually every
alternative involves an opportunity cost. In Example 3 above, for instance, the higher income that
could be realized in future years as a result of returning to school is an opportunity cost of staying in
his present job.
c) Sunk Cost:- A sunk cost is a cost that has already been incurred and that cannot be changed by
any decision made now or in the future. Because sunk costs cannot be controlled and avoided by
any decision.
To illustrate a sunk cost, assume that a company paid $50,000 several years ago for a special-purpose
machine. The machine was used to make a product that is now obsolete and is no longer being sold.
Even though in hindsight purchasing the machine may have been unwise, the $50,000 cost has already
been incurred and cannot be undone. And it would be folly to continue making the obsolete product in
a misguided attempt to “recover” the original cost of the machine. In short, the $50,000 originally paid
for the machine is a sunk cost that should be ignored in current decisions.
d) Budgeted cost: - Predicted or forecasted cost (future cost) as distinguished from an actual or
historical cost.
e) Standard cost: - is a carefully determined cost of a unit of output or per unit cost of a product for
example, the standard direct manufacturing labor cost of a jacket at Webb.
1.4. Linear, curvilinear and step functions of costs
A cost function is a mathematical representation of how a cost changes with changes in the level of an
activity relating to that cost.
1.4.1. Linear cost function
Linear cost function is graphically represented by straight line, having a constant slope value with
degree one. Graphically it is represented as follows;

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Linear total cost function graphical representation

12000

10000

8000

6000

4000

2000

0
1 2 3 4 5 6 7 8 9 10 11
Qty
TC= Total variable cost + Total fixed cost
= Variable cost per units * units produced + total fixed cost
The slope of linear equation is determined by the change in total cost due to the change in activity
level. Where variable cost per unit indicates the slope of total cost function.

Variable cost per unit = Rise = y2-y1

Run x2-x1
Example: - A manufacturer produces 80 units of a particular product at a cost of $ 220,000 and 125
units at a cost of $ 287,500. Assume the cost curve to be linear.
a. Find variable cost per unit
b. Find total fixed cost
c. Find the total cost of 95 units.
Solution
Let y= total cost x= units produced
Given:- y1 = 220,000 x1= 80 y2= 287,500 x2= 125
a) Per unit variable cost
Using slope equation
y = mx + b
m= y2-y1
x2-x1
m = 287,500-220,000
125-80

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m= 67,500
45
m = 1,500
Using simultaneous equation
80x + b = 220,000 ………………………………equation 1
125x + b = 287,500……………………………..equation 2

80x + b = 220,000
-125x - b = -287,500 (multiply by -)
-45x = -67,500
-45 -45
X= 1500
b) Total fixed cost
Total cost = Total variable cost + total fixed cost
Y = mx +b
Using the first equation above can calculate it total fixed cost as;
80x+b=220,000
X= 1500
80 (1,500)+b = 220,000
120,000+b= 220,000
b = 220,000-120,000
b = 100,000 (Total fixed cost)
Using the second equation total fixed cost calculated as;
125x+b= 287,500
125 (1500) + b = 287,500
b = 287,500- 187,500
b = 100,000 (Total fixed cost)
c) Total cost of 95 units
Total cost = total variable cost + total fixed cost
= VCQ + TFC
= 1500 (95) + 100,000
= 142,500 + 100,000
= 242,500

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1.4.2. Curvilinear function
Many costs do not vary in a strictly linear relationship with volume. Rather, costs may vary in a
curvilinear pattern—a 10% increase in volume may yield an 8% change in total variable costs at lower
output levels and an 11% change in total variable costs at higher output levels. We show a curvilinear
cost pattern below.

One way to deal with a curvilinear cost pattern is to assume a linear relationship between costs and
volume within some relevant range. Within that relevant range, the total cost varies linearly with
volume, at least approximately. Outside of the relevant range, we presume the assumptions about cost
behavior may be invalid.
Costs rarely behave in the simple way that would make life easy for decision makers. Even within the
relevant range, the assumed cost behavior is usually only approximately linear. As decision makers, we
have to live with the fact that cost estimates are not as precise as physical or engineering
measurements.
1.4.3. Step cost function
A step cost remains constant at a certain fixed amount over a range of output (or sales). Then, at certain
points, the step costs increase to higher amounts. Visually, step costs appear like stair steps. It is cost
that increase in total with steps when the volume changes to a particular level Step costs are also
known as semi fixed costs.
Supervisors’ salaries are an example of a step cost when companies hire additional supervisors as
production increases. For instance, the local McDonald’s restaurant has one supervisor until sales
exceed 100 meals during the lunch hour. If sales regularly exceed 100 meals during that hour, the
company adds a second supervisor. The supervisor costs will remain the same for between 0 – 100
meals served that hour. When meals served are between 101–200, the supervisor cost goes up to

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reflect 2 supervisors. Step costs will increase by the same amount for each new cost or step. Step costs
are sometimes labeled as step variable costs (many small steps) or step fixed costs (only a few large
steps). In graph form, a step cost would appear as:

1.4.4. Regression analysis for costs

Regression analysis is a powerful tool for forecasting because it is a statistical method that measures
the average amount of change in the dependent variable associated with a unit change in one or more
independent variables. It uses a formula i.e. Y = a + β X. The linear regression takes into account each
and every figure, and only then processes it further. Its y-intercept ( a ¿ and slope (b) represents the
total fixed cost and variable cost per unit respectively, can be calculated by solving the following linear
equations of least-squares regression analysis.
n ∑ xy−∑ x ∑ y
Variable cost per unit = β =
n ∑ x 2−( ∑ x ) 2
∑ y−b ∑ x
Fixed cost ¿ a =
n
Where,
n=number of observations
x = the level of activity (independent variable)
y= the total mixed cost (independent variable)
a = the total fixed cost (the vertical intercept of the line)
β = the variable cost per activity (the slope of the line)
∑X= sum of the given X values.
∑X2 =sum of square of the x values.
∑Y= sum of the given y Values.

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∑XY= sum of the amounts obtained by multiplying each of the given X values by the
associated observed Y value.
Activity 2:- QPR Company a whole seller of large, custom built air conditioning units for commercial
buildings has noticed considerable fluctuation in its shipping expenses from month to month, as shown
below:
Month Units Shipping
Sipped Cost
January…………………… 4 $2,200
February…………………. 7 $3,100
March.................................. 5 $2,600
April................................... 2 $1,500
May..................................... 3 $2,200
June..................................... 6 $3,000
July ..................................... 8 $3,600
Total …………………… 35 18,200
Required:
a) Calculate correlation coefficient and state your interpretation.
b) Find variable cost per unit using regression (beta value)
c) Find total fixed cost using regression (alpha value)
d) State equation of the above data and state your interpretation.

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